Trading System Basics, Part I

Portfolio Management
by Tim Justice

“There are old traders; there are bold traders; but there are no old, bold traders.” ~Anonymous

In the past we’ve discussed different types of analysis designed to aid your trading. One type is the fundamental approach, which involves closely examining the company to get an impression of growth potential. We can also look at developing a holistic view of the financial world through inter-market analysis. The different independent financial markets give clues about the pressures that move the stock market. We use this inter-market information to find the best market sectors and the best stocks in those sectors. Next, we look at technical analysis as a measurement of market action. Even utilizing these technical, quantitative tools, there’s still much left to interpretation. However, these tools do allow us to be more systematic in our trading.

You need to learn these subjects in order to fast track the development of your trading system. You’ll want to develop a defined trading regiment that includes a set of rules for systematic interpretation of the general markets, an individual company, and determining when to execute your trade. This style of trading will allow you to develop and fine-tune your strategies. It’ll also let you track and monitor the success rates of your system and help you guard against emotional investing.

In this newsletter, we’ll discuss how to manage risk in your portfolio. Risk is an essential part of trading. Making a trade can be thought of as a decision to take risk. Most successful trading systems have a disciplined approach to risk. You’ll need to determine how much risk you’re willing to take in each position as well as your overall account. We’ll avoid teaching absolutes like always risking a set amount or always cutting losses here or there. Much of your risk determination will depend on the time frame you trade as well as the volatility of the underlying instrument you’re trading. If you’re a day trader, your risk analysis should be done differently than if you’re buying a stock to hold it for an investment. You’ll want to develop risk aversion techniques like setting stop losses and portfolio management, as well.

Risk Management

It’s important that you start to develop a system for tracking trade executions and quantifying success rates, failure rates, and capitol drawdowns. Once you track and quantify your trading system, you can begin to manage your risk.
There are essentially three elements involved in a stock trade:

1. What to buy

2. When to buy

3. How to execute the trade

Risk management has everything to do with how to execute the trade. Your risk management rules will tell you how much to invest; these rules will analyze diversification, reward-to-risk ratio, success rates, and drawdowns. This is the element of trading that nearly everyone neglects, but is vital to the success of your trading system development. It’s very difficult to make consistent money in the stock market without a proper system of risk management. It can be done, but more often than not trading systems fail without proper money management.

For example, suppose your trading system develops successful trades 80% of the time. When you’re right, you win an average of $100,000; while when you are wrong, you lose $5,000. If you start with an account size of $10,000 and lose your first trade, you are now down to $5,000. Frustrated but still hopeful, you try again… and lose a second time in a row. That’s it, end game. You’re out of money. You hit your 20% losing streak on your first two trades, completely wiping you out. Even though your chances of winning far outweigh your chances of losing, even though you make profitable trades more often than losing ones, you have already lost your ability to trade due to poor risk and money management decisions.

Here are some general guidelines to help you get started developing money management rules. Please note that these are more guidelines than rules. Always use discretion when trading.

First, being fully invested in the market exposes you to risk. Many traders will keep some of their money in cash to manage risk. To trade, you need to put money in the market, but having cash on hand does two very important things. One, it makes sure that if market risk happens due to an economic event like a key news release, then you don’t take the full brunt of the adverse move. Second, if you are fully invested, how can you make any more trades? By keeping some money in cash, you keep bullets in your clip. When an opportunity presents itself, you can take action.

Second, risk no more than you’re willing to lose on any given trade. This means that your losses should never exceed your risk tolerance of your account size. This seems self evident, but many new traders fail to examine potential risk in their trade. When you make a new trade ask yourself: if I’m wrong, how much will I lose? Try to project possible scenarios that the stock can go through. How much will you lose if stopped out? How much will you lose if the stock gaps against you? Responsible traders are aware of the downside. If you can properly manage your risk, then the rewards will be there.

Third, in the beginning, stay away from over leveraging. If you knew your account would be successful 80% of the time, you would be trading as often as you could, right? Even in this scenario, would you put most of your account out at risk on one single trade? Because losing happens, you need to avoid over leveraging. The money in your account can be thought of as your employees in your trading business. Keep them working, but don’t put their jobs at risk. So how much do you put in? The appropriate amount of size in a position will change from trader to trader.

Think about it like this: if you’re trading a blue-chip liquid stock that doesn’t move very fast and an IPO startup that moves very fast, the risk potential is very different in each situation. You’ll want to recognize the risk in the position you’re taking and always make sure that your losses don’t become too excessive.

Diversification

Any discussion on risk should be accompanied with a discussion on diversification. Diversification is a strategy of investing in different markets, products, and time frames. Account diversification reduces your exposure to risk. Since no two people share exactly the same level of risk tolerance, diversification is highly personalized and difficult to quantify. If you’re too diversified, large winnings in one market may be averaged down by small winnings and losses in other trades. On the other hand, you definitely don’t want to put all your proverbial eggs in one market basket.

If you’re looking to minimize risk, you may want to try diversification. There are many ways to diversify. Buying 20 stocks will clearly be more diversified than buying two. It doesn’t have to end there, though. If you mix long term positions with short term positions, you can also diversify your account. One great way to diversify is to have bearish positions mixed in with your bullish positions. Market risk is the risk that every trader deals with. If a hurricane hits the gulf coast, the market may react negatively. If you are entirely in bullish positions then your account will take a deep drawdown. If you have a mix of bullish and bearish positions, it can reduce the impact of market risk. Diversifying in different products can accomplish the same thing. Many traders use stocks, bonds, futures, and options concurrently. If you have a good mix of products and positional direction, you can reduce the risk in your account.

Depending on your personal tolerance for risk and your investment objectives, the amount of diversification can change from trader to trader. Remember, it’s easy to be completely focused on the prize, but you have to ask yourself: how much am I willing to pay to get it?

Reward to Risk Ratio

Each trade will present a potential reward versus potential risk. The word potential is key. We really don’t know how much money we can make on a trade. It can be much greater (or less) than we anticipated. Using reward to risk ratios can be a method to help identify potential. Let’s examine 3 hypothetical trading systems to show how the actual reward to risk may differ from trader to trader. In the first trading system, let’s assume a day trader has an expectancy to be correct 70% of the time in his trades. Based on this success rate he decides to set a stop loss and target at equal levels from his entries. This would be a reward-to-risk assumption of 1:1. When he profits he profits as equally as the loss he takes when he loses. For this trader’s system, 1:1 reward to risk would work fine.

In the second trading system, let’s say a swing trader has an expectancy to be correct 50% of the time. Based on his success rate he decides to set a target twice as high as his stop loss. When he profits he makes twice as much as the loss he takes when he loses. Based on the success rate he needs to have a higher reward-to-risk potential in his trades. This trader would need to find trades that offered more upside potential than the day trader.

In the third trading system, let’s assume a speculator who trades aggressively has a success rate of 30%. He only wins one in three trades roughly. When he wins he wins big though at 5 times the amount of loss that he takes. His reward-to-risk potential is 5:1. The trader looks for situations that offer big upside potential when he’s right but realizes that he won’t be right that often.

Which system is best? Well in all three of our examples the traders would be profitable based on the success rates and accompanying reward-to-risk assumptions. The answer though, is that none of them are best. They are all just dynamically different. The important point is that you need to understand your success rate and then you can set stop and targets based on your assumed rate. Some people would say, why not trade the 70% success rate system and look for potential trades that offer 5:1 reward to risk? Why not get the best of both worlds? Well if you can find a system that works that way then absolutely go for it. In the trading world most often the higher amount of reward you expect or demand the lower probability you have of actually getting there. Again, the only way to know what potential you have in your techniques will be to trade them a lot so that you can get enough results to know what to expect. Paper trading can serve this function. Most traders will practice any new strategy vigorously until they can make valid assumptions about its potential. For many of you these strategies you’ve learned will be your first exposure to a trading system. You will need to practice them over and over again to get an idea of how they work.

Success Rates

So how often does a trader need to be right to have success? Let’s examine the idea of success rates through an analogy. Let’s assume there is a basket of ping pong balls. In the basket, the balls are colored red and white. 40 of the balls are red and they represent losing trades while 60 of the balls are white and represent winning trades. Every time you reach in and grab a white ball you have a profit while when you pull a red ball you have a loss.

If this were the market, you’d be reaching your hand in as fast as you can and pulling out ping pong balls, right? Maybe. Success rates are only a part of the equation. As we examined before, you need to also equate for how much reward you have potentially versus the risks you are taking. In our example, what if you lost $2 for every red ball but only gained $1 for the white ones? You likely wouldn’t be so eager to reach in. Would you be surprised to hear that many trading systems have more losing trades than winning trades? Would it surprise you more to hear that many of those traders are actually profitable in the end? You don’t have to have a positive success rate to make money in the market. The key to success in these types of systems is that the money you make on your winning trades must be greater than the money you lose on your losing trades. What kind of system are you trading? Well the techniques can convert into a success rate and reward-to-risk potential that can vary greatly from trader to trader. If you use the techniques and apply them to long term trading, you’ll have certain results and if you apply them to day trading, you’ll have other results.

The bottom line is this: we’ve given you a blueprint, but your results will be different from someone else’s. Think about it: if you focus in on using only the bullish retracement strategy, do you think that your results will be different from a trader who uses a balance of all four entry techniques? They should be. It will be smart to keep track of your results so that you have an expectation of what you can assume based on the types of trades you take and how well you execute them.

Drawdowns

The term drawdown refers to the total amount of money your trading system will lose during a losing trade or losing streak. Many new traders approach the market with the assumption that if they can just learn the perfect strategy, they can be right all of the time. When they see losses start to accumulate, the assumption is that either the strategy doesn’t work or that they’re not doing it right. It’s hard to build confidence when you’re losing. Hopefully if you have a good idea of how drawdowns are a natural part of a trading system, it won’t shake you too much if and when you run into a losing streak. Let’s go back to our analogy of the ping pong balls. This time, let’s say that when you pull a white ball it gives you a $2 gain and a red ball gives you a $1 loss. This system has a positive success rate (60%) and a positive reward to risk ratio (2:1). This is a good trading system.

How do you suppose it’ll feel if you pulled out 10 red balls in a row? You might start to question your system. Your confidence might slip. What if you were highly leveraged and those 10 balls in a row caused us to draw our account down 50% of its value? In trading, you never know when you’re going to run into a losing streak. Even the best traders in the market experience them. In many ways, how you handle the losses in trading can define how well your system runs. Every system will experience drawdowns. The goal in account management is to keep the drawdowns to a minimum so that you don’t have such a long climb back up. There are many things you can do to reduce the size of potential drawdown in your account. Diversification, position size, and stop loss techniques can help reduce drawdowns.

You’ll need to determine what you’re comfortable with. As has been said before, remember to always ask yourself: how much am I at risk if this doesn’t work? That amount needs to be a comfortable amount. When you trade comfortably, you can simply pull out as many ping pong balls as you can because you know you have a winning system that won’t be too deeply affected by drawdowns.

Trading Losses and Emotions

We are programmed to win. We want to win, we like to win, and even if we lose, we find some way to justify why we should have won. Be careful! This win at all cost attitude is terrible for trading since we become emotional when we hit a losing streak. Every trader, from the beginner to the veteran, will at some point gets into a rut where things just don’t work out. From childhood, we’ve been taught to stand up to a bully and never quit in the face of adversity. You will want to embrace these mindsets in regards to entrepreneurship, taking risk, building your trading business, and furthering your education. You do not want to bring these mindsets to any one individual trade. There is nothing wrong with selling a trade for a loss. You will have to take each situation on a case by case basis but realize that you will lose on some trades. It’s natural. Sometimes, the only way to get onto the next profitable trade is to get rid of that current losing one. You may have the best trading system in the world and still hit a losing streak. How are you going to deal with it? On the other hand, how are you going to handle a winning streak?

How will you handle being on top? One day a young dog goes out to play in the back yard of his house. He’s approaching adulthood, so he’s strong and quick but still playful like a puppy. He sees a tree house in the back of the yard and knowing how much fun the kids have when they play in it, he’s determined to climb up. He makes attempt after attempt until finally he figures a way to climb the wooden steps and reach the top. Finally! He reached his goal through hard work and ingenuity. He then looks around and sees that it isn’t as much fun as he thought it would be. As he approaches the door and looks down his entire perspective then changes. What seemed easy to do going up now seems impossible to deal with. Of course, panic then sets in.

What does this have to do with trading? Well, from time to time new traders get into the market. Through hard work, education and ingenuity they are soon reaching their goals and their dreams seem achievable. After some success, some traders start to get a little too arrogant and then the dreaded overleveraging occurs. Like in the example with the dog, you need to know what you’re going to do when you reach the top. If your account grows exponentially, how will you react? The point is this: know what you’re going to do in the face of success and failure. In previous sections we’ve discussed how to handle losses. It is also important to know how you’re going to handle the winning. It may seem self-evident, but I bet you’ll be surprised. Expect to succeed, and be ready for it when it gets there.

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All investing and trading in the securities market involves risk. Any decisions to place trades in the financial markets, including trading in stock or options or other financial instruments, is a personal decision that should only be made after thorough research, including a personal risk and financial assessment, and the engagement of professional assistance to the extend you believe necessary.

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All investing and trading in the securities market involves a high degree of risk. Any decisions to place trades in the financial markets, including trading in stocks, options or other financial instruments, is a personal decision that should only be made after conducting thorough independent research, including a personal risk and financial assessment, and prior consultation with the user’s investment, legal, tax and accounting advisers, to determine whether such trading or investment is appropriate for that user.